Monthly Archives: October 2008

There has been a great deal of talk regarding deflation recently. Today, Nouriel Roubini predicted that deflation will be the main concern of policy makers in the next six months. James Hamilton disagrees. Nevertheless, the drastic fall in housing prices and the recent crash in the money multiplier warrant a closer look.

At the onset of the Great Depression, the Fed was already in contractionary mode. The subsequent banking failures of 1930 – 1933 caused a flight to cash as many removed their money from banks. This flight to cash resulted in a severe monetary contraction as money moved from banks to mattresses (or so the saying goes). This monetary contraction led to the worst deflation in U.S. history with percentage price declines in the double digits. Now we have talked about irrational fears of deflation before, however, when deflation is the result of an excess demand for money, the effects can be quite disastrous.

The recent discussion regarding deflation begs the question as to whether we are currently in the midst of a monetary contraction.

On the supply-side, we are clearly not in a contractionary environment. However, as our friend David Beckworth points out, the money multiplier of the monetary base has declined substantially since June. Beckworth (as well as Hamilton) attribute this decline to the fact that the Fed is now paying interest on excess reserves. While Beckworth’s accompanying graph provides ample evidence that bank reserves have drastically increased, a closer look at the data suggests that the spike in reserves began in August (two months after the decline began in the money multiplier).

I draw two conclusions from the previous analysis. First, we are entering (or have entered) a contractionary monetary environment. Keynes’s theory of the liquidity preference is proving as poignant as ever as individuals are fleeing the stock market and other investments for the security of cash. Second, foreclosures are squeezing bank balance sheets and counter-party risk remains elevated (as is continually evident from the LIBOR-OIS spread). Given that the Fed is introducing new facilities each day to ensure that it has to tools necessary to combat the crisis, this implies that cautious banks are simply building excess reserves (and the Fed is now rewarding them for doing so). The result is a massive reduction in the money multiplier.

Thus far, the Fed has been very responsive. The reduction in the money multiplier has been met by a significant increase in the monetary base. So long as the Fed remains proactive, I am prepared to agree with James Hamilton that deflation is not on the horizon.

Some of my colleagues still talk of the possibility of a liquidity trap, in which the central bank supposedly has no power even to cause inflation. Their theory is that interest rates fall so low that when the Fed buys more T-bills, it has no effect on interest rates, and the cash the Fed creates with those T-bill purchases just sits idle in banks.

To which I say, pshaw! If the U.S. were ever to arrive at such a situation, here’s what I’d recommend. First, have the Federal Reserve buy up the entire outstanding debt of the U.S. Treasury, which it can do easily enough by just creating new dollars to pay for the Treasury securities. No need to worry about those burdens on future taxpayers now! Then buy up all the commercial paper anybody cares to issue. Bye-bye credit crunch! In fact, you might as well buy up all the equities on the Tokyo Stock Exchange. Fix that nasty trade deficit while we’re at it! Print an arbitrarily large quantity of money with which you’re allowed to buy whatever you like at fixed nominal prices, and the sky’s the limit on what you might set out to do.

Of course, the reason I don’t advocate such policies is that they would cause a wee bit of inflation. It’s ridiculous to think that people would continue to sell these claims against real assets at a fixed exchange rate against dollar bills when we’re flooding the market with a tsunami of newly created dollars. But if inflation is what you want, put me in charge of the Federal Reserve and believe me, I can give you some inflation.

Our friend George Selgin has alerted me to a discussion of his new book, Good Money. The book is currently sitting in my “to read” stack, but I have not had a chance to get started yet. The conversation is excellent (thereby elevating the book in the stack).

Selgin’s work has had a great influence on my thinking with regards to free banking, banking crises, and monetary policy. You can find an excellent summary of his research on his website.

Discussion about the current financial crisis has largely devolved into a debate about regulation. What’s more, the general public has been led to believe that economic theory has little to say about the current crisis. In reality, the multitude of work on bubbles, crises, business cycles, and credit crises is far too vast to summarize in a book, let alone one thousand words. What should be clear, however, is that an understanding of the current crisis must begin with a description and explanation of the preceding boom. Along these lines, insight can be obtained from the writings of two prominent economists of the early twentieth century, F.A. Hayek and John Maynard Keynes.

Throughout much of the past decade, the main economic debate in the United States centered on the behavior of real wages. As the economy continued to grow, wages by and large failed to keep up after adjusting for inflation. This data point largely resulted in a partisan debate between those who blamed the recent changes in tax policy and those who blamed rising health care costs (total compensation, after all, was rising even if wages were not). With the onset of the current financial crisis this discussion has faded into the background. Nevertheless it is important to understand the bizarre characteristics of the boom in order to fully understand the current situation and to draw inferences for policy analysis. As alluded to previously, a meaningful explanation of the boom-bust scenario of the past decade can be found by reading the major work of Hayek and Keynes.

For Hayek, policies of price level stabilization are the source of business cycle fluctuations as they advocate having the money supply move in lockstep with real economic growth. Such stabilization policies are consistent with the Federal Reserve policies during the tenure of Alan Greenspan. Thus during the early part of this decade when productivity was growing at a record pace putting downward pressure on prices, Greenspan was attempting to stabilize prices through the lower interest rates facilitated by increases in the money supply.

The explanation of the boom-bust scenario that follows from attempts at price level stabilization is provided most forcefully in Hayek’s Price and Production, a collection of lectures given at the London School of Economics in the early 1930s. According to Hayek, when the government increases the money supply and thereby lowers interest rates, it results in more roundabout methods of production that would previously be unprofitable under higher interest rates. Since this increase in production activity is not the result of private saving, consumers continue to anticipate the same level of expenditures on consumption. The result is a temporary boom as spending on production goods increases and individuals maintain consumption expenditures.

However, boom is not sustainable. The increased competition for resources due to the lower interest rates cause the price of the goods used in the production process to rise and therefore translates to higher prices for consumer goods as well. Consumers therefore have to sacrifice some part of what they used to consume. This is not the result of a voluntary choice, but rather the fact that they can now purchase less consumer goods with their current income. However, when the monetary expansion concludes and the money has made its way to workers through higher incomes, they will be able to resume the previous proportion of consumption by increasing expenditures. This change will force the structure of production to become less roundabout and therefore capital which was sunk into areas that are now unprofitable will result in a loss and the onset of a downturn in the business cycle.

Before discussing the downturn, it is important to discuss the implications that can be drawn from the artificial boom. As one can easily infer from the previous description of the boom, while workers are receiving higher nominal incomes, their real incomes are simultaneously depressed by rising prices. In other words, in the absence of another source of growth, real wages will be stagnant.

This scenario clearly fits with what we saw for the better part of this decade. Alan Greenspan lowered interest rates and left them low for far too long in an attempt to stabilize the price level and prevent an economic downturn in the wake of a mild recession. The result was an artificial boom in which real wages were largely stagnant and growth was narrowly concentrated.

Even though Hayek’s theory provides an ample explanation of the artificial boom, it does not imply that a financial crisis akin to what we are experiencing will necessarily follow. For an understanding of the financial crisis, we must turn to John Maynard Keynes.

A central theme of Keynes’s General Theory of Employment, Interest, and Money is the role of uncertainty in economic behavior. As the eminent scholar on Keynes, Paul Davidson has repeatedly highlighted the fact that the world in which we live is largely non-ergodic, or incapable of probabilistic prediction. For Keynes, uncertainty was not merely a term for the improbable, rather it was the concept that there are events in which there exists no identifiable or predictable probability distribution of outcome. It is in this sense that securitization and the subsequent financial market collapse can be put into context.

In addition to stimulating demand, the low interest rates created a quest for yield amongst those in the financial industry. The subsequent result was the increase in the utilization of debt securitization. The conversion of illiquid to liquid assets stoked the fire of the housing market as mortgage debt (and later other types of debt as well) could be removed from the balance sheets of these institutions and the influx of the proceeds could be used for further lending. Armed with what many believed to be assets whose risk followed well-behaved probability distributions, securitization spread to other forms of debt such as student loans, credit card debt and to the securitization of the securities themselves. This idea of quantifiable risk similarly led to the misguided use of credit default swaps to insure against losses.

When the housing price bubble burst and foreclosures spread, the realization of the uncertainty (unquantifiable risk) associated with the various form of asset-backed securities, various equity and debt market behavior devolved quickly into that described by Lord Keynes in Chapter 12 of his General Theory. The weight given to prospective yield fell drastically as market participants increasingly applied greater weight to the expectations of their fellow participants. The subsequent result is found in the herd-like behavior that continues to plague the markets.

Additionally, Keynes’s discussion of the liquidity preference and the determination of the market interest rate are of particular note here as well. As Keynes explicitly explained using his theory of the liquidity preference in 1937, the “desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future.” There is scant a time when this statement has been more prescient. Markets have been plummeting precisely because of the growing of such “distrust” as individuals have sought to escape from the uncertainty surrounding debt and equity markets and instead hold a greater proportion of cash. Further, this preference for liquidity, as Keynes detailed, is what determines the interest rate relative to the money supply. Thus as individuals struggle to understand why credit spreads that reflect the risk of associated with lending such as that between the LIBOR and the Overnight Indexed Swap (OIS) continue to widen, one need only look to the theory of interest outlined in the General Theory. Inter-bank lending rates such as the LIBOR remain elevated due to the fact that, for lack of a better phrase, cash remains king. Until confidence is restored, such conditions are likely to persist.

This analysis is by no means the only example of what economic theory has to say about the current financial crisis and the preceding boom. However, this analysis should serve to demonstrate that, looking back on the past six years or so, the artificial boom and subsequent bust in the United States, which is now spreading throughout the world, can be better understood in light of the pioneering work of F.A. Hayek and John Maynard Keynes. Until we begin to take uncertainty seriously and understand the limitations of price level stabilization, no amount of regulation or intervention will prevent such a crisis in the future.

(1) Fannie and Freddie (the GSEs) gained market share beginning in the 1980s from the saving institutions (presumably from the Saving & Loan debacle fall out); (2) Fannie and Freddie lost market share beginning around 2002 to the asset-backed security issuers. As noted by the above observers, this latter point supports the notion that at least some of the problems at Fannie and Freddie emerged in response to their declining market share during the housing boom. In other words, what happened to Fannie and Freddie may have been a symptom rather than a cause of the housing boom-bust cycle.

I have mentioned this before, but it is worth repeating. There is no doubt that Fannie and Freddie have played a role in elevating home prices through the subsidization that followed from the implicit guarantee of their debt by the federal government and their growth over the years. However, their share of the market declined for the better part of this decade as private issuers expanded their presence within this market. It was the pyramid schemes of collateralized debt obligations (CDOs), CDOs comprised solely of CDOs (CDO-squared and subsequently CDO^n), regulatory forbearance (not solely de-regulation), the unbelievable assumptions regarding risk (see here, here, here, and here for a discussion of uncertainty) and credit default swaps, an irrational fear of deflation that caused the Federal Reserve to keep interest rates at historic lows for far too long, etc. that caused the current financial crisis.